"A question that sometimes drives me hazy: am I or are the others crazy?" - Albert Einstein
And if indeed NIRP is a currency play, given James Tobin's objective was to mitigate currency volatility, no doubt to us that the latest bout of volatility witnessed on the Japanese yen is indeed some form of a "reverse Tobin tax". What we find amusing is that James Tobin was influenced by the earlier of John Maynard Keynes on general financial transaction taxes and the famous chapter XII of the General Theory on Employment Interest and Money. Keynes was an avid speculator and the recent NIRP put in place by various generous gamblers aka central bankers, is leading to a renewed frenzy of speculation in the bond market where all the fun is with more and more bonds yielding on the negative side and their prices reaching new record high levels:
"Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation." - John Maynard Keynes, page 104.
"I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.
Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward..." - John Maynard Keynes
"The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States." - John Maynard Keynes, page 105.
In this week's conversation, we will look again at the credit cycle and the issue with correlations with diversification we recently discussed. We will as well look at how NIRP will be playing out credit wise and trouble brewing in Asia.
- Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months
- Macro and Credit - The US late stage will have nasty credit consequences on Asia
- Final chart: US Rates skew may reflect policy mistake / recession risks
- Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months
"The consequence for this means that classical theories based on allocation become more and more challenged in a NIRP world because correlation patterns change in a crisis period particularly when correlations are becoming more and more positive (hence large standard deviations move)." - Macronomics, February 2016When it comes to "correlations" we read with interest Société Générale's take from their Multi Asset Snapshot note from the 26th of February entitled "A balanced portfolio for an imperfect world":
"While we may have been too aggressive with a balanced allocation before the market downturn, we're not keen to take the revolving door and go risk averse now. We are recommending a balanced allocation. The average correlation between assets has recently pulled back, making us more convinced to keep the current allocation of 50% equities/50% bonds and others.
- source Société Générale
"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by this sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world." - source Macronomics, February 2016
In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out
We quoted Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:
"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets
What we are currently seeing is a repricing of bond volatility which had been "anesthetized" by central bankers leading to Cushing's syndrome. Central bankers meddling with interest rates levels have led investors to get out of their comfort zone and extend both their risk exposure and duration, taking the repressed volatility regime as an empirical factor in their VaR related allocation risk process. Now they are rediscovering in the ongoing turmoil that, yes indeed long duration exposure is more volatile than shorter ones. They are also rediscovering "convexity" with artificially repressed yields. They are being significantly punished the more exposed to "credit" duration they are." - Macronomics, May 2015
"Mom-and-pop investors are rushing into Swiss properties just as the market faces its greatest threat of a bubble in a quarter century.
“I see two protracting trends,” Patrik Gisel, chief executive officer of Swiss Raffeisen, the country’s third-largest bank, said in an interview in Zurich. One involves big money -- institutional investors such as pension funds and insurance companies who have invaded the market, driven by negative yields on Swiss government bonds. More recently, a new group of investors has entered the fray, buying properties to rent or develop rather than for a primary residence.
“What’s really new is that private investors are piling in to buy real-estate assets for yield due to limited options,” he said. These aren’t ultra-rich speculators, rather well-to-do people looking to build nest eggs at a time of record-low interest rates and market turmoil. Although they are still just a small part of the market, “this is reducing the professionalism,” he said.
Raiffeisen, a cooperative encompassing about 300 regional banks, is one of Switzerland’s five systemically relevant banks, along with UBS Group AG and Credit Suisse Group AG. It holds about 17 percent of the Swiss mortgage market, with home loans representing about 95 percent of the total volume of 166 billion francs ($166 billion) at the end of the 2015.
The Swiss property market is facing the greatest threat of a real estate bubble since 1991, UBS said in a report this month on the subject. Loan applications for properties not occupied by owners dipped in the fourth quarter, yet remain historically elevated at about 18 percent of the overall demand. House prices rose 0.5 percent from the third quarter and around 2 percent yearly.
While the risk of default on mortgages remains low in Switzerland, vacancy rates are rising, with prices “driven by investments, not by the need for living space,” Gisel said. Unlike in countries including the U.K. and U.S., Swiss buyers traditionally are looking to make a lifetime investment as capital gains taxes make it costly to speculate.
Gisel, formerly the deputy CEO who succeeded Pierin Vincenz at the head of Raiffeisen last year, said he sees a “soft landing” in the property market. The bank said during its earnings report Friday that prices are stabilizing at a high level or declining slightly.
Swiss apartment prices and mortgage lending climbed by about a third between 2007 and 2014. A price increase of 2 percent would have been unappealing just four years ago, Gisel said.
The Swiss National Bank introduced charges on bank deposits in an effort to weaken the franc, which soared after it lifted its three-year-old cap on the currency in January 2015. Some big banks such as UBS and Credit Suisse have passed on the pain of negative interest rates to their larger institutional clients. Retail clients have been spared, for now.
“Equities are too risky for many private investors, bonds don’t yield anything,
so people go for real estate but often have a poor understanding of this market,” says Fredy Hasenmaile, head of real estate research at Credit Suisse. Inexperienced investors tend to underestimate the costs associated to maintain a property." - source Bloomberg
"The issue with enticing a high home ownership rate is the level of household debt it generates. It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.
"A host of U.S. energy companies joined LCD’s distressed debt Restructuring Watchlist last week, adding to an already hefty group of issuers from that still-struggling market segment.
The Watchlist tracks companies with recent credit defaults or downgrades into junk territory, issuers with debt trading at deeply distressed levels, as well as those that have recently hired restructuring advisors or entered into credit negotiations.
"In a low real interest rate environment, however, such as the 1970s or the present, the four year period of stability disappears and the credit cycle becomes much shorter. Chart 3 illustrates this:
Table 2 above implies that the global credit cycle is, as always, relatively synchronous, with the US leading EM by around six months. Assuming two-year widening and two-year tightening cycles, with a peak of the cycle in early 2016 and a trough in late 2017 or early 2018, this implies the following:
"European investors will still be hungry for yield. European ten-year yields have fallen almost 50 basis points this year, with the Bund yielding just over 10bp. It’s hardly surprising that European insurance companies are steering their clients away from guaranteed life products, as our insurance analyst Rotger Franz has noted, but they are still left with legacy products that need to be funded. Our SG shortfall model estimates the current gap between what insurers need and what the government markets are offering at almost 140bp.
Given this gap, we think the demand for credit will remain strong. It’s worth noting, however, that this demand will be much stronger in the BBB area than in the AA and A area, since spreads have compressed too much in those areas to offer the returns that investors need." - source Société Générale.
- "Emerging market sovereigns will not be able to bail out their corporates: The ratio between EM sovereign spreads and corporate spreads has narrowed this year, when the mismatches in the indices are accounted for. Yet EM corporate debt – either domestic debt as a percentage of GDP, or external debt as a percentage of reserves – is often much bigger than government debt, as we noted in "Can EM sovereigns really bail out their corporates?" We think this year, investors will realise that many EM corporates will not be bailed out by their sovereigns.
- EM defaults will be higher and recovery rates lower than the market expects. Given the weakness of commodity prices and the weakness of EM currencies, we are more bearish about these issuers than we are about US high yield issuers." - source Société Générale
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.We also added at the time:
"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.
Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates)." - source Macronomics August 2013While the PBOC might have indeed bought some time in adding more liquidity, the worrying trend of capital outflows have yet to meaningfully slow down, meaning for us that, indeed Asia should as well be the focus of more attention, but not only China...
- Macro and Credit - The US late stage will have nasty credit consequences on Asia
"• Cheap oil has not benefited Asia’s energy-importing economies as much as it had in the past. In early 2008, if you responded “sub-6%” to the question of how fast Asia ex-Japan’s economies would grow if oil prices halved and most Asian central banks slashed rates to new, or near, record lows, you would have been scoffed at. More of the oil windfall appears to have been saved or offset by the China slowdown, weak EM demand, high domestic leverage and low productivity growth.
• That said, the commodity price drop has been a big differentiator in favour of Asia, as fundamentals and growth have fared better in Asia vis-à-vis LatAm and EEMEA. Asia is the least ugly in EM, at least for now. If risk sentiment turns, Asia may experience a short-run relief rally, buoyed by: 1) still ample global liquidity; 2) any signs of China growth stabilising, albeit it would be temporarily, in our view; and 3) more discriminating investors in global emerging markets in Asia’s favour.
• However, more fundamentally the seeds are being sown for a credit crunch and financial stress in Asia:
1) high and still-rising private debt, combined with still elevated property prices; 2) slowing potential growth rates; 3) increasing foreign-currency debt exposure; 4) large herding-like investments by global asset management companies in Asia (‘original sin II’); 5) the Fed surprising with more/faster rate hikes; and 6) China’s economy facing a secular slowdown in growth in 2016 and 2017." - source Nomura
"Asia is setting itself up for a credit crunch
• The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can cause financial decelerator effects.
• Cheap credit has weakened productivity by misallocating capital (eg. property speculation), dis-incentivising supply-side reforms and keeping zombie companies alive. Potential growth is slowing across most of Asia.
• Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.
• Triggers of a credit crunch could be the market caught off-guard by Fed rate hikes, USD sharp appreciation, a China setback, or a high profile Asian corporate default prompting global asset managers to pull out from the region en masse and causing market liquidity to evaporate.
Asia’s credit and property price gaps are sending warning signals
• Pioneering work at the BIS by Claudio Borio and Philip Lowe in the early 2000s found that over a 4-year horizon a credit gap of >4% predicted 88% of crises in industrial countries with a noise to signal ratio (NSR) of 0.21, while an equity gap >60% predicted 67% of crises with an NSR of 0.15. Jointly they predicted 73% of crises with an NSR of 0.02 (i.e., issued wrong signals only 2% of the time).
• Since then more studies, including of EM crises, have reaffirmed that credit is the single best predictor of crises and, with better data, property prices are generally found to be more important than equity prices.
• In a more recent 2011 BIS study (working paper No. 355) of 36 advanced and EM countries it was found that over a 3-year horizon, a credit gap >10% predicted 67% of crises with an NSR of 0.16, and a property gap >10% predicted 77% of crises with an NSR of 0.33. This is an ominous sign for Asia, as highlighted in the table below.
The best indicator of financial crises is the credit gap; the property price gap is also a strong indicator, and jointly they send a strong signal
(click to enlarge picture)
"Hong Kong could be Asia's flashpoint
HK stuck between a rock (Fed hikes) and a hard place (ebbing China)
• Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 112% (they have corrected 11%), and the ratio of private non-financial credit to GDP has surged to 293%.
• The real effective exchange rate has risen 26% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015.
• Foreign assets and liabilities have surged since 2008. this leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.
• Economic hardship could ignite further political and social unrest, or vice versa, ahead of the 2016 Legco elections (around Sep) and 2017 chief exec elections. We would not rule out a change to the HKD peg regime." - source Nomura
"The Hong Kong dollar advanced 0.18 percent this month to HK$7.7724 against its U.S. counterpart, the biggest increase since October 2011, data compiled by Bloomberg show. The currency rose 0.06 percent on Monday to trade near the strong end of its HK$7.75-HK$7.85 trading range.
“The Hong Kong dollar was one of the biggest speculative targets in January, especially amid fears of the yuan being devalued,” said Irene Cheung, a foreign-exchange strategist at Australia & New Zealand Banking Group Ltd. in Singapore. “We need to watch the yuan, given how it’s affecting sentiment across markets. If the dollar-yuan rate continues to remain broadly stable, there’s no reason to focus on the Hong Kong-dollar peg for now.”
The Hong Kong dollar was linked to the greenback in 1983, when negotiations between the U.K. and Beijing over the city’s return to Chinese rule spurred an exodus of capital, and policy makers in 2005 committed to limiting declines to the current range.
Hong Kong’s yuan deposits rose by 0.1 percent to 852 billion yuan in January, the Hong Kong Monetary Authority said on Monday. The pool posted its first annual decline last year, while issuance of Dim Sum bonds fell for the first time since the market’s inception in 2007." - source Bloomberg
"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
When it comes to the fate of the HKD peg, Nomura has been solacing our concerns in their note:
"HKD re-pegged to the RMB?
The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported
US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed accelerates hiking and China’s growth keeps slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura
- Final chart: US Rates skew may reflect policy mistake / recession risks
"• US rates skew is now inverted in both short- and long-dated expiries, despite more dovish Fed expectations
• We believe this, at least in part, reflects higher perceived odds of a policy mistake and/or growth shock ahead
• From a historical standpoint, inverted long-dated skew is consistent with late stages of the hiking cycle
Inverted skew: Not a good sign for the Fed
A notable recent development in the US rates vol market is the inversion of the skew surface, with low strikes trading at a premium to high strikes. Short-dated skews were first to invert earlier this year. Today skews are inverted across the board, including very long expiries (Chart above). Importantly, the skew inversion occurred against expectations of a more dovish Fed. The market now sees the next Fed hike only by 4Q17, a much less hawkish outlook than FOMC projections. Lower rates coupled with expectations of a more accommodative Fed normally imply upward risks to rates. Yet, the volatility market sees risks to rates skewed on the downside even at very long horizons.To hike in March, or not to hike, that is the question...
We believe this is a worrisome signal to policy makers. The inversion of the skew all the way into longer horizons suggests perceived risks go beyond the recent financial stress and may reflect greater perceived odds of a policy mistake/recession risks. Inverted long-dated skew is consistent with late stages of hiking cycles." - source Bank of America Merrill Lynch
"Insanity - a perfectly rational adjustment to an insane world." - R. D. Laing, Scottish psychologistStay tuned!